Tax News and Developments North America Client Alert May 16, 2019 The New 2019 QOZ Proposed Regulations and Their Impact on the Life Cycle of a Qualified Opportunity Fund I. Introduction The second round of qualified opportunity zone (“QOZ”) guidance was released on April 17, 2019 and published in the Federal Register on May 1, 2019 (the “2019 Proposed Regulations”), substantially clarifying several key issues which continued to give pause to would-be investors of a qualified opportunity fund (“QOF”), even after the first round of proposed regulations was released on October 19, 2018 (the “2018 Proposed Regulations”). Notably, the 2019 Proposed Regulations clarify some of the most important aspects of a QOF’s life cycle, including the initial startup requirements, operation of a QOF, and exiting a QOF investment. Although the 2019 Proposed Regulations address many open questions and ambiguities arising from the 2018 Proposed Regulations, some questions and issues remain unanswered or underdeveloped, necessitating careful planning in order to avoid various foot faults. The Internal Revenue Service (“IRS”) and the US Department of Treasury (“Treasury”) stated that they expect to address the administrative rules relating to QOFs that fail to maintain the 90% investment standard and other information-reporting requirements for eligible taxpayers in separate regulations, forms, or publications. This client alert addresses the following key issues from the 2019 Proposed Regulations over the life cycle of a QOF, followed by relevant planning observations: investment of Section1 1231 capital gains; investment of property other than cash; mixed-funds investments; exceptions to working capital safe harbor; properties straddling QOZs; reinvestments inside a QOF; acquisition of unimproved land; acceleration of deferred gain from inclusion events; disguised sale rules; and use of leased property, among others. 1 All section references provided for herein refer to the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury Regulations promulgated thereunder. Baker McKenzie 2 Tax News and Developments - Client Alert May 16, 2019 II. QOF Formation Issues A. Qualifying and Non-Qualifying Investments Taxpayers can make qualifying investments in a QOF by transferring cash or other property. The 2019 Proposed Regulations make it clear that a taxpayer may make a qualifying investment by transferring cash or other property to a QOF, regardless of whether the transfer is taxable to the transferor (e.g., a contribution that does not qualify for Section 351 non-recognition treatment), so long as the transfer is not re-characterized as a transaction other than an investment in the QOF (e.g., a partnership contribution recast as a disguised sale). If a taxpayer transfers property other than cash to a QOF in a carryover basis transaction (e.g., a Section 721(a) contribution), the 2019 Proposed Regulations provide special rules for determining the amount of an investment for purposes of the deferral election. In such a case, the amount of the investment equals the lesser of (1) the taxpayer’s adjusted basis in the equity received in the transaction (determined without regard to the basis rules in Section 1400Z-2(b)(2)(B) (e.g., initial zero basis in investment and subsequent increases at five-year and seven-year marks)) or (2) the fair market value of the equity received in the transaction (both as determined immediately after the transaction). This rule applies separately to each property contributed to the QOF, and the taxpayer’s initial basis in the qualifying investment is zero. The 2019 Proposed Regulations provide that in order to determine whether the partnership disguised rules under Section 707 apply to an investment in a QOF partnership, (1) cash contributed is treated as noncash property, and (2) the partner’s share of liabilities is treated as zero in the case of a debt-financed distribution. If the QOF partnership’s distribution of property to a partner would be a disguised sale after these assumptions are made, then the partner’s original transfer of deferred gain to the partnership will not be treated as an investment that is eligible for a deferral election. Please see Exhibit A, Topic #6 for related QOZ planning observations. Only net Section 1231 gain is eligible for deferral through a QOF investment. The 2018 Proposed Regulations clarified that only capital gains are a qualifying investment, eligible for deferral under Section 1400Z-2(a)(1). The 2019 Proposed Regulations further provide that for any gain arising from Section 1231 property, only capital gain net income can be deferred through a QOF investment. The 180-day period for such QOF investment Baker McKenzie 3 Tax News and Developments - Client Alert May 16, 2019 begins on the last day of the taxpayer’s taxable year. Section 1231 gain generally results from sales and exchanges of property used in a trade or business and held over one year. A net Section 1231 gain is treated as long-term capital gain, while a net Section 1231 loss is treated as an ordinary loss. This rule could deter taxpayers with Section 1231 gains early in the year from making an investment in a QOF because if they have Section 1231 losses later in the year, part (or all) of the earlier Section 1231 gain would be recast as a non-qualifying investment and, in turn, the taxpayers would not be afforded the QOZ tax incentives. Please see Exhibit A, Topic #2 for relevant QOZ planning observations. Mixed-funds investments (qualifying and non-qualifying Investments) are allowed. The 2019 Proposed Regulations set forth two special rules that treat a taxpayer as having created a “mixed-funds investment.” First, a mixedfunds investment will result if a taxpayer contributes to a QOF, in a nonrecognition transaction, property that has a fair market value in excess of the property’s adjusted basis. Second, a mixed-funds investment will result if the amount of the investment that might otherwise support an election exceeds the amount of the taxpayer’s eligible gain for investment in a QOF. In each instance, the excess (i.e., the excess of fair market value over adjusted basis, or the excess of the investment amount over eligible gain, as the case may be) is treated as a non-qualifying investment, which is not afforded the tax benefits for a qualifying investment. If a partner holds both a qualifying investment and a non-qualifying investment in a QOF partnership, the partner is treated as holding two separate interests in the QOF partnership. The basis of each interest is computed separately (e.g., Section 704(b) allocations of income, gain, loss, and deduction). If a partner’s interests are increased by subsequent contributions, then such interests are valued before the transaction and allocation percentages adjusted to reflect the relative values of these separate interests. Please see Exhibit A, Topics #4 and #5 for relevant QOZ planning observations. Taxpayer may acquire a direct investment in a QOF from someone other than the QOF. The 2019 Proposed Regulations provide that a taxpayer can make a qualifying investment in a QOF by acquiring a QOF interest from someone other than the QOF. The amount of the qualifying investment in the hands of the acquirer is the amount of cash, or the fair market value of the other property, as determined immediately before the exchange. Baker McKenzie 4 Tax News and Developments - Client Alert May 16, 2019 The amount of such qualifying investment is limited to the gain eligible for deferral under the QOZ rules. On the other hand, if a taxpayer transfers property with built-in gain to a seller of QOF interest in exchange for an interest in a QOF, the taxpayer’s gain that is realized from such exchange is ineligible for deferral through investing in a QOF. Please see Exhibit A, Topic #3 for relevant QOZ planning observations. Carried interests for services are not a qualifying investment. The 2019 Proposed Regulations provide that any interest received in exchange for services is not a QOZ investment eligible for any of the QOZ tax benefits. Thus, a service provider’s interest would be split between the qualifying investment relating to invested capital gains, if any, and the non-qualifying investment received for the performance of services. Please see Exhibit A, Topic #1 for relevant QOZ planning observations. B. Investors from Consolidated Groups Members of consolidated group may not invest and defer capital gain realized by another member of the group. The 2019 Proposed Regulations provide that in order to qualify for gain deferral, the same member of a consolidated group must sell a capital asset to an unrelated person, elect to defer the gain and invest an amount of such deferred gain or less from the original sale into a QOF. The QOF and the member may be related. In other words, a member of a consolidated group may invest in a QOF that the consolidated group owns. III. QOF Operation Issues: The Asset Tests A. 90% Asset Test and 70% Substantially-All Test Newly contributed assets may be excluded from the 90% asset test. The 2019 Proposed Regulations allow a QOF to apply the 90% asset test without taking into account any investments received in the preceding six months of the testing date, as long as the new assets are being held in cash, cash equivalents, or debt instruments with terms of 18 months or less. This benefits QOFs by giving them additional time to deploy new capital if such capital is received shortly before a testing date. Baker McKenzie 5 Tax News and Developments - Client Alert May 16, 2019 A QOF can choose between two methods to evaluate its assets for purposes of the tests. For purposes of satisfying the 90% asset test and the 70% “substantially all” test, the 2019 Proposed Regulations allow a QOF to use either the applicable financial statement valuation method or an alternative valuation method. Once one of these valuation methods is selected for the taxable year, it must apply such method consistently to all of its assets with respect to the taxable year, but it may change its method year to year. Under the “applicable financial statement valuation method,” the value of owned or leased tangible property is the value of that property as reported on the applicable financial statement for the relevant reporting period. The 2019 Proposed Regulations allow the applicable financial statement valuation method only if the applicable financial statement is prepared according to US GAAP, and for leased property, the lease of the tangible property must be recognized. Under the “alternative valuation method,” the value of tangible property that is owned by the QOF is its unadjusted cost basis of the asset under Section 1012. The value of tangible property leased by the QOF is determined based on a calculation of the present value of the lease payments for the use of the tangible property. Specifically, the value of such leased tangible property under these 2019 Proposed Regulations is equal to the sum of the present values of the payments to be made under the lease for such tangible property. The 2019 Proposed Regulations require that a QOF or a QOZ business (“QOZ Business”) using the alternative valuation method calculate the value of leased tangible property under this method at the time the lease for such property is entered into. Leased tangible property may be qualifying QOZ business property for purpose of the 90% asset test and the 70% “substantially all” test. The 2019 Proposed Regulations provide that leased tangible property meeting certain criteria may be treated as QOZ business property (“QOZ Business Property”) for purposes of satisfying the 90% asset test and the 70% “substantially all” test, if (1) leased tangible property is acquired under a lease entered into after December 31, 2017, and (2) substantially all (70%) of the use of the leased tangible property is within a QOZ during substantially all (90%) of the period for which the business leases the property. Baker McKenzie 6 Tax News and Developments - Client Alert May 16, 2019 B. 50% Gross Income Test The 2019 Proposed Regulations provide that in order to be a “qualified business entity” with respect to a taxable year, a corporation or partnership must derive at least 50% of its total income from the active conduct of a business within a QOZ. The 2019 Proposed Regulations define a trade or business as a trade or business within the meaning of Section 162. The “active conduct of a trade or business” will not have the same meaning for purposes of other provisions of the Code, including Section 355 (relating to tax-deferred “spin-off” transactions). The 2019 Proposed Regulations grant three safe harbors and a factsand-circumstances test for satisfying the qualified business entity requirement. The businesses need to meet only one of the following to satisfy the safe harbor test. 1. The “Hours Safe Harbor”: At least 50% of the services performed (based on hours) for such business by its employees and independent contractors are performed within the QOZ; 2. The “Compensation Safe Harbor”: At least 50% of the services performed for the business by its employees and independent contractors are performed in the QOZ, based on amounts paid for the services performed; or 3. The “Property & Management Safe Harbor”: A trade or business may satisfy the 50% gross income requirement if (1) the tangible property of the business that is in a QOZ and (2) the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade of business. Further, a facts-and-circumstances test is available for taxpayers not meeting any of the safe harbor tests: based on all the facts and circumstances, at least 50% of the gross income of a trade or business must be derived from the active conduct of trade or business in the QOZ. Solely for the purposes of Section 1400Z-2(d)(3)(A), the ownership and operation (including leasing) of real property is the active conduct of a trade or business. However, merely entering into a triple-net-lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer. Please see Exhibit A, Topic #14 for related QOZ planning observations. Baker McKenzie 7 Tax News and Developments - Client Alert May 16, 2019 C. Original Use and Substantial Improvement Tests Original use of a property depends on whether it was placed in service in a QOZ for purposes of depreciation or amortization. The 2019 Proposed Regulations clarify what “original use” means for tangible property acquired by purchase. The 2018 Proposed Regulations required that tangible property acquired by purchase either (1) have its “original use” in a QOZ commencing with a QOF or a QOZ Business, or (2) be substantially improved (i.e. adjusted basis of the property (excluding land) should be doubled), in order to qualify for QOZ tax benefits. The 2019 Proposed Regulations provide that the “original use” of tangible property acquired by purchase commences on the date when any person (1) first places the property into service in a QOZ for purposes of depreciation or amortization, or (2) first uses the property in the QOZ in a manner that would allow depreciation or amortization if that person were the property’s owner. Thus, if a taxpayer other than the QOF or QOZ Business depreciates or amortizes the tangible property located in a QOZ (or could have done so), the QOF or QOZ Business would not satisfy the “original use” requirement. Please see Exhibit A, Topic #11 for related QOZ planning observations. Used property may satisfy the original use test. The 2019 Proposed Regulations clarify that used tangible property will similarly satisfy the “original use” requirement, so long as the property has not been previously used within that QOZ in a manner that would have allowed it to be depreciated or amortized by any taxpayer. The 2019 Proposed Regulations also provide that a property’s history of prior use is disregarded if the property has been vacant for at least five years. The original use and substantial improvement tests are inapplicable to leased property. The 2019 Proposed Regulations clarify that an “original use” requirement does not apply with respect to tangible property leased from an unrelated party, in part because leased property held by a lessee generally cannot be placed in service for depreciation or amortization. Tangible property leased from a related party must meet the original use requirement, and if it does not meet the original use requirement, the lessee must become the owner of tangible property having a value at least equal to the value of the leased property. A lessee of the tangible property does not need to “substantially improve” the property. However, if any improvements are made by a lessee to leased tangible property, such improvements (1) satisfy the “original use” Baker McKenzie 8 Tax News and Developments - Client Alert May 16, 2019 requirement and (2) are considered purchased property for the amount of the unadjusted cost basis of such improvements, determined in accordance with Section 1012. Please see Exhibit A, Topic #8 for related QOZ planning observations. Original use and substantial improvement tests are different for land (improved or unimproved) and other real property. If land within a QOZ is acquired by purchase, the requirement that the original use of tangible property in the QOZ commence with the QOF is not applicable to the land, whether the land is improved or unimproved. Further, such unimproved land is not required to be substantially improved, subject to certain anti-abuse provisions to be provided by the Treasury in the future. However, land can be treated as QOZ Business Property only if it is used in a trade or business of a QOF or QOZ Business, and only activities giving rise to a trade or business within the meaning of Section 162 may qualify as a trade or business for purposes of Section 1400Z-2. Land would not qualify as QOZ Business Property if held solely for investment. Please see Exhibit A, Topic #12 for related QOZ planning observations. Conversely, if real property other than land that is acquired by purchase has been placed in service in the QOZ by a person other than the QOF or QOZ Business (or first used in a manner that would allow depreciation or amortization if that person were the property’s owner), such real property must be substantially improved to be considered QOZ Business Property. Under the 2019 Proposed Regulations, the “substantial improvement” requirement for tangible property that is purchased is determined on an asset-by-asset basis, but the IRS and Treasury are considering applying an aggregate standard to provide additional compliance flexibility, and are accepting comments on this question. Please see Exhibit A, Topic #9 for related QOZ planning observations. D. Tests for Real Property Straddling a QOZ Boundary The 2019 Proposed Regulations provide that the portion of the real property located inside the QOZ must be “substantial,” and the portion(s) of the real property located outside the QOZ must be “contiguous” with a portion of the development property real estate located inside the QOZ. However, the Proposed Regulations render inconsistent guidance regarding how the “substantial” test can be satisfied. Future Treasury Baker McKenzie 9 Tax News and Developments - Client Alert May 16, 2019 guidance will hopefully eliminate the inconsistency identified below in the 2019 Proposed Regulations. Real property located inside the QOZ must be “substantial” compared to real property located outside the QOZ. The Preamble to the 2019 Proposed Regulations adopts the parallel requirements of Section 1397C(f) and provides that real property straddling a QOZ will be deemed “substantial” if the unadjusted cost of the real property located inside a QOZ is greater than the unadjusted cost of real property located outside the QOZ. Under this method of analysis, real property straddling a QOZ boundary will be deemed to be located entirely within a QOZ if the value of the real estate for the development project located inside the QOZ is “substantial” in comparison to the value of the real estate for the development project located outside the QOZ. Please see Exhibit A, Topic #16 for related QOZ planning observations. Inconsistently, Section 1400Z-2(d)(5)(viii) of the 2019 Proposed Regulations provides that real property straddling a QOZ boundary will be deemed to be located inside the QOZ if the square footage of the real property located inside the QOZ is considered “substantial.” Such real property straddling a QOZ will be deemed “substantial” if the real property located inside the QOZ is substantial compared to the real property located outside the QOZ, in each case based on square footage. Please see Exhibit A, Topic #16 for related QOZ planning observations. Real property located outside the QOZ must be “contiguous” with development project real estate located inside the QOZ. In addition to the tests above regarding “substantial” real property located inside a QOZ, the 2019 Proposed Regulations provide that all real estate for a given QOZ development project that is located outside a QOZ must be “contiguous” with QOZ development project real estate that is located inside the QOZ. The parcels of real estate located outside the QOZ must touch a portion of the real estate located inside the QOZ at a point or along a boundary. E. QOZ Business’s Intangible Property Test: 40% Test A QOZ Business must use a substantial portion of its intangible property in the active conduct of the business. For purposes of this test, the term ‘‘substantial portion’’ means at least 40%. Baker McKenzie 10 Tax News and Developments - Client Alert May 16, 2019 F. Special Rule for Inventory in Transit The 2019 Proposed Regulations also provide a safe harbor for the “use” of inventory in transit. Inventory (including raw materials) of a trade or business does not fail to be used in a QOZ solely because the inventory is in transit (1) from a vendor to a facility of the trade or business located within a QOZ, or (2) from a facility of the trade or business that is in a QOZ to customers of the trade or business that are not located in a QOZ. IV. QOF Operating Issues: Other Requirements and Restrictions A. Inclusion Events A list of “inclusion events” that cause QOF investors to recognize their deferred gain were newly added. The 2019 Proposed Regulations list inclusion events that result in a QOF investor recognizing an amount of deferred gain. Statutorily, the amount of gain that is deferred if a taxpayer makes a qualifying investment will be included in the taxpayer’s income in the taxable year that includes the earlier of (1) the date on which such investment is “sold or exchanged,” or (2) December 31, 2026. The 2019 Proposed Regulations clarify that, as a general principle, an inclusion event results from a transfer of a qualifying investment in a transaction to the extent the transfer reduces the taxpayer’s equity interest in the QOF. A transaction that does not reduce a taxpayer’s equity interest in the taxpayer’s QOF may also be an inclusion event to the extent the taxpayer receives property from a QOF in a transaction treated as a distribution. Please see Exhibit A, Topics #6 and #7 for related QOZ planning observations. The 2019 Proposed Regulations provide taxpayers with a nonexclusive list of 11 inclusion events, including transfers by gift (unless the gift is a transfer of a qualifying investment to a grantor trust), claim of worthlessness, liquidation or termination of the QOF, and receiving property in a distribution, all subject to exceptions. The most critical exception being tax-deferred transfers to partnerships. (Please see Section 721 discussion below.) Each of the enumerated transactions within the 2019 Proposed Regulations is an inclusion event because each would reduce or terminate the taxpayer’s direct (or, in the case of partnerships, indirect) qualifying investment or, in the case of distributions, would constitute a “cashing out” of the taxpayer’s qualifying investment. As a result, the Baker McKenzie 11 Tax News and Developments - Client Alert May 16, 2019 taxpayer would recognize all, or a corresponding portion, of its deferred gain. The 2019 Proposed Regulations provide that transfers of property by gift or a charitable contribution are inclusion events. However, the distribution of a qualifying investment to a beneficiary by an estate or by operation of law is not an inclusion event. Please see Exhibit A, Topic #7 for related QOZ planning observations. The 2019 Proposed Regulations specify the amount of gross income includible after an inclusion event. Generally, other than with respect to QOF partnerships, if a taxpayer has an inclusion event with regard to its qualifying investment, the taxpayer includes in gross income the lesser of the following two amounts, less the taxpayer’s basis: (1) the first amount is the fair market value of the portion of the qualifying investment that is disposed of in the inclusion event; (2) the second amount is the amount that bears the same ratio to the remaining deferred gain as the first amount bears to the total fair market value of the qualifying investment in the QOF immediately before the transaction. For inclusion events involving QOF partnerships, the amount includible is equal to the percentage of the qualifying QOF partnership interest disposed of, multiplied by the lesser of the following: (1) the remaining deferred gain less any basis adjustments pursuant to Section 1400Z2(b)(2)(B)(iii) and (iv); or (2) the gain that would be recognized by the partner if the interest were sold in a fully taxable transaction for its then fair market value. For inclusion events involving a QOF shareholder that is an S corporation, if the S corporation undergoes an aggregate change in ownership of more than 25%, there is an inclusion event with respect to all of the S corporation’s remaining deferred gain. Partner’s transfer of its interest in a QOF partnership will generally be an inclusion event except for contributions to a partnership under Section 721. The 2019 Proposed Regulations provide that the transfer by a partner of all or a portion of its interest in a QOF partnership, or in a partnership that directly or indirectly holds a qualifying investment, will generally be an inclusion event. However, a transfer in a transaction governed by Section 721 (partnership contributions) or Section 708(b)(2)(A) (partnership mergers) is generally not an inclusion event, provided there is no reduction in the amount of the remaining deferred gain that would be recognized under Section 1400Z-2 by the transferring partners on a later inclusion event. Please see Exhibit A, Topic #7 for related QOZ planning observations. Baker McKenzie 12 Tax News and Developments - Client Alert May 16, 2019 Partnership distributions, if in the ordinary course of partnership operations, may in certain instances, also be considered inclusion events. Under the 2019 Proposed Regulations, the actual or deemed distribution of cash or other property with a fair market value in excess of the partner’s basis in its QOF partnership interest is also an inclusion event. Please see Exhibit A, Topic #6 for related QOZ planning observations. The rules applicable to C corporations and their shareholders (i.e., subchapter C of chapter 1 of subtitle A of the Code) apply to S corporations and their shareholders unless the rules are inconsistent with the provisions of subchapter S (e.g., flow-through principles). The 2019 Proposed Regulations provide that a conversion of an S corporation that holds a qualifying investment in a QOF to a C corporation (or a C corporation to an S corporation) is not an inclusion event. B. Requirements for Leased Tangible Property The 2019 Proposed Regulations allow a QOF or QOZ Business to lease tangible property from a related party, while a QOF or QOZ Business must acquire tangible property, by purchase, from an unrelated party. Whether a lease is acquired from a related party or not, the lease under which a QOF or QOZ Business acquires rights with respect to any leased tangible property must be a “market rate lease,” which is determined under the Section 482 regulations. If the lessor and lessee are related, additional requirements apply. Specifically, the leased tangible property will not qualify as QOZ Business Property if, in connection with the lease, a QOF or QOZ Business at any time makes a prepayment to the lessor (or a person related to the lessor), relating to a period of use of the leased tangible property that exceeds 12 months. Further, the lessee must become the owner of tangible property that is QOZ Business Property, and it must have a value not less than the value of the leased personal property. Please see Exhibit A, Topic #8 for related QOZ planning observations. For leased tangible personal property, if its original use does not commence with the lessee, the lessee must become the owner of an equal amount, in value, of tangible property that is QOZ Business Property during a relevant testing period. The testing period begins on the date that the lessee receives the leased tangible personal property and ends on a date that is earlier of (1) the date 30 months after the date that the lessee received the property or (2) the last day of the term of the lease. Baker McKenzie 13 Tax News and Developments - Client Alert May 16, 2019 Finally, the 2019 Proposed Regulations include an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property (other than unimproved land). Please see Exhibit A, Topic #12 for related QOZ planning observations. V. QOF Operating Issues: Capital Deployment A. Working Capital Safe Harbor The rules for working capital safe harbor were updated. The 2019 Proposed Regulations make two changes to the safe harbor for working capital. First, the written designation for planned use of working capital now includes the development of a trade or business in the QOZ, in addition to the previously listed acquisition, construction, and/or substantial improvement of tangible property. Second, exceeding the 31-month period does not violate the safe harbor if the delay is attributable to waiting for government action, the application for which is completed during the 31-month period. Please see Exhibit A, Topic #15 for related QOZ planning observations. B. QOF’s Reinvestment of Proceeds A QOF has one year to reinvest its proceeds from sale or disposition of QOZ Business Property, QOZ stock, or QOZ partnership interests. A QOF may reinvest the proceeds it receives from sale or disposition of QOZ Business Property, QOZ stock, or QOZ partnership interests, and have them treated as QOZ property for purposes of the 90% asset test, as long as the QOF reinvests the proceeds during the 12-month period beginning on the date of such sale or disposition. Importantly, the proceeds must be continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less. A QOF that holds real property may be eligible to reinvest through a Section 1031 exchange and still satisfy the 90% asset test under this reinvestment rule. However there are a number of clarifications needed with a Section 1031 exchange if done at the lower-tier partnership level, such as (1) whether the 12-month reinvestment period applies to lowertier partnerships, (2) whether the lower-tier partnerships should hold the proceeds continuously in cash, cash equivalents, or debt instruments with a term of 18 months or less; and (3) whether the replacement Baker McKenzie 14 Tax News and Developments - Client Alert May 16, 2019 property will satisfy the “acquired by purchase” requirement for tangible property when there is a carryover tax basis. In addition, the 2019 Proposed Regulations provide that such sales or dispositions of assets by a QOF do not affect investors’ holding periods, or trigger the inclusion of deferred gain so long as the investors do not sell or otherwise dispose of their investment in the QOF. Please see Exhibit A, Topic #17 for related QOZ planning observations. VI. QOF Operating Issues: Distributions QOF partnership’s debt-financed distributions are generally allowed, subject to outside basis and disguised sale limitations. The 2019 Proposed Regulations generally allow debt-financed distributions, evidenced by an example which describes a QOF borrowing money on a non-recourses basis and distributing it to the partners who had made a qualifying investment in the QOF. For example, A and B form a QOF partnership and each contributes $200 that is deferred in accordance with the QOZ rules. A few years later, the QOF partnership obtains a non-recourse loan from a bank for $300. Under Section 752, the loan is allocated $150 to each partner. The QOF partnership then distributes $50 to A, when the values and the bases of the investments are the same. The 2019 Proposed Regulations explain that in this case, the distribution is not an inclusion event causing A to recognize gain because the distribution does not exceed A’s basis. A’s basis in its qualifying investment is $150 at the time of the distribution: sum of the original zero basis ($0) with respect to the contribution and the debt allocation ($150). Because the distribution amount of $50 is less than A’s basis of $150, no gain is recognized; however, A’s basis in the QOF partnership is reduced to $100. It is important to note that the general restrictions applicable to distributions apply here as well. As such, the distribution should not exceed the partner’s tax basis for non-recognition of the deferred gain, and the disguised sale rules under Section 707 may apply to recharacterize the original transfer of the gain as a non-qualifying investment. Please see Exhibit A, Topics #6 and #7 for related QOZ planning observations. Baker McKenzie 15 Tax News and Developments - Client Alert May 16, 2019 VII. Exiting a QOF A. Sale of QOF Assets Generally QOFs are allowed to be somewhat flexible for purposes of reinvesting their proceeds and satisfying the 90% asset test. However, QOFs and investors in QOFs are not exempt from the US Federal income tax consequences if QOFs or QOZ Businesses dispose of QOZ property before the 10-year holding period expires, even if the proceeds are reinvested within 12 months. The IRS and Treasury explained that the statutory language does not expressly grant them the authority to allow QOFs or their investors to avoid recognizing gain on the QOF’s sale or disposition of assets under Sections 1001(c) and 61(a)(3). However, they requested commenters to provide prior examples of regulations, if any, that exempt realized gain from being recognized under Sections 1001(c) or 61(a)(3) when no statute expressly provides for non-recognition treatment. It is, at best, unclear if additional QOF and investor-favorable rules may be forthcoming in future guidance on this point. Please see Exhibit A, Topic #17 for related QOZ planning observations. B. Taxpayers Holding Qualifying Investments in a QOF Partnerships, REIT, or S Corporations for at Least 10 Years Can Exempt Capital Gain Allocations The 2019 Proposed Regulations provide a crucial exit strategy to taxpayers who hold their qualifying investments in a QOF partnership, REIT, or S corporation. If a taxpayer holds a qualifying investment in either a QOF partnership, REIT, or S corporation for at least 10 years, then when the QOF disposes of the QOZ property after the 10-year holding period (which disposition would be reported on the K-1 and be attributable to the qualifying investment), the taxpayer may elect to exclude its share of the capital gain (or capital gain dividends) from its gross income for the taxable year in which such capital gain would be included in the taxpayer’s gross income otherwise. If the taxpayer’s K-1 separately states capital gains that arise from the sale or exchange of any particular capital asset, the taxpayer may make such election with respect to the separately stated item. For basis purposes, the excluded amount is treated as an item of income described in Sections 705(a)(1) or 1366 and increases the partners or the shareholders’ bases by their shares of such amount. Note that the 2019 Proposed Regulations do not provide a similar election to holders of qualifying QOF stock of a QOF C corporation that is not a QOF REIT. Baker McKenzie 16 Tax News and Developments - Client Alert May 16, 2019 This election may provide less benefits to a QOF investor than the sale of QOF interests because depreciation recapture and gain from nonqualifying assets are not eliminated in this case. Please see Exhibit A, Topics #18 and #19 for related QOZ planning observations. VIII. Rules Applicable to the Entire Lifecycle of a QOF A. Anti-Abuse Rule The anti-abuse rule requires that the QOZ rules be applied in a manner that is consistent with the purposes of the rules. The 2019 Proposed Regulations provide a general anti-abuse rule: if a “significant purpose” of a transaction is to achieve a tax result inconsistent with the purposes of QOZ rules, such transaction (or a series of transactions) can be recast for US Federal income tax purposes. The tax results of the transactions are evaluated based on all the facts and circumstances. The 2019 Proposed Regulations provide the following as an abusive transaction: a QOF acquires a parcel of land that is utilized by a business to produce an agricultural crop (whether active or fallow at that time), and treats the parcel as a QOZ Business Property without investing any new capital investment in (or increasing any economic activity or output of) the parcel. The IRS and Treasury request comments on whether antiabuse rules under Section 1400Z-2(e)(4)(c), in addition to the general anti-abuse rule, are needed to prevent such transactions or “land banking” by QOFs. Additional guidance on anti-abuse rules may be provided in the next set of guidance from the IRS and Treasury. B. Definition of “Substantially All” “Substantially all” generally means 70% for “use” but is 90% for holding periods. The 2019 Proposed Regulations provide that in testing the “use” of QOZ Business Property in a QOZ, the term “substantially all” means 70%, regardless of whether the tangible property is owned or leased. However, the 2019 Proposed Regulations provide that the term “substantially all” as used in the holding period context is 90%. Baker McKenzie 17 Tax News and Developments - Client Alert May 16, 2019 C. Holding Period of QOF Investment The holding period for a QOF investment is determined without regard to the taxpayer’s holding period of such property prior to the transfer to a QOF. The 2019 Proposed Regulations provide that a QOF investor’s holding period for its qualifying investment does not include the period during which the QOF investor held property that was transferred to the QOF in exchange for the qualifying investment. Thus, if an investor transfers a building that it owned for 10 years to a QOF partnership in exchange for qualifying QOF partnership interest, the investor’s holding period for the qualifying QOF partnership interest begins on the date of the transfer and not when the investor first acquired the building. The 2019 Proposed Regulations clarify that this general rule does not apply when a QOF shareholder receives (1) qualifying QOF stock in a qualifying Section 381 transaction, in which the acquiring corporation is a QOF immediately thereafter, or (2) qualifying QOZ stock in a recapitalization of a QOF. In these cases, the QOF shareholder’s holding period for such qualifying QOF stock will include the holding period of the QOF shareholder’s qualifying QOF stock exchanged therefor. This exception also applies to QOF stock received in a qualifying Section 355 transaction. The IRS and Treasury explained that a QOF shareholder should be permitted to tack its holding period for its initial qualifying investment when the investor’s direct equity investment in a QOF continues. D. Timing of Basis Adjustments An electing taxpayer’s initial basis in a qualifying investment is zero. However, a taxpayer’s basis in its qualifying investment is increased automatically after holding such qualifying investment for five years by an amount equal to 10% of the deferred gain, and then again after the qualifying investment has been held for seven years by an amount equal to an additional 5% of the deferred gain (to the extent the five or sevenyear period ends on or before December 31, 2026). The 2019 Proposed Regulations clarify that such basis is considered basis for all purposes of the Code. For example, losses suspended under Section 704(d) would be available to the extent of the aforementioned basis step-up. The 2019 Proposed Regulations also clarify that basis adjustments under Section 1400Z-2(b)(2)(B)(ii) (i.e., the recognition of deferred gain upon the earlier of December 31, 2026 or an inclusion event) are made Baker McKenzie 18 Tax News and Developments - Client Alert May 16, 2019 immediately after the amount of deferred capital gain is taken into income. If a basis adjustment is made as a result of a reduction in direct ownership of a qualifying investment (e.g., a redemption, a distribution treated as gain from the sale or exchange of property, or a distribution to a partner of property with a value in excess of the partner’s basis in the qualifying QOF partnership interest), such basis adjustment is made before determining the tax consequences of the inclusion event with respect to the qualifying investment (e.g., before determining the recovery of basis under Section 301(c)(2)). Finally, if the taxpayer makes an election under Section 1400Z-2(c), such basis adjustment is made immediately before the taxpayer disposes of its qualifying investment. IX. Conclusion Although the 2019 Proposed Regulations provide clarity on many outstanding issues giving pause to investors, fund managers, and other seeking to take advantage of the incentives provided by QOZs, they leave several questions unanswered, notably the following: the specifics of the reporting requirements for initial self-certification and for annual reporting of compliance with the 90% asset test, or the imposition of penalties on those who fail to maintain the required 90% investment standard, in addition to other areas of ambiguity that need additional guidance and clarification. As such, the 2019 Proposed Regulations will still require significant attention, and another round of proposed guidance from the IRS and Treasury is expected to be issued. Treasury announced that it would accept comments on the 2019 Proposed Regulations by July 1, 2019. www.bakermckenzie.com For additional information please contact the authors of this Client Alert or any member of Baker McKenzie’s North America Tax Practice Group. Daniel Cullen +1 312 861 8162 daniel.cullen @bakermckenzie.com Steven Schneider +1 202 452 7006 steven.schneider @bakermckenzie.com Sam Kamyans +1 202 835 6207 sam.kamyans @bakermckenzie.com Peter Matejcak +1 312 861 7523 peter.matejcak @bakermckenzie.com Mary Yoo +1 312 861 4226 mary.yoo @bakermckenzie.com Tax News and Developments is a periodic publication of Baker McKenzie's North America Tax Practice Group. This Alert has been prepared for clients and professional associates of Baker McKenzie. It is intended to provide only a summary of selected recent legal developments. For this reason, the information contained herein should not be relied upon as legal advice or formal opinion or regarded as a substitute for detailed advice in individual cases. The services of a competent professional adviser should be obtained in each instance so that the applicability of the relevant jurisdictions or other legal developments to the particular facts can be verified. To receive Tax News and Developments directly, please contact email@example.com. Your Trusted Tax Counsel® www.bakermckenzie.com/tax ©2019 Baker & McKenzie. All rights reserved. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an "office" means an office of any such law firm. This may qualify as "Attorney Advertising" requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome. Baker McKenzie 19 Tax News and Developments - Client Alert May 16, 2019 Exhibit A Baker McKenzie Observations: 2019 QOZ Proposed Regulations QOF Formation Considerations Topic 2019 Proposed Regulations Baker McKenzie Observation 1. No QOZ tax benefits for a carried interest Question: Is a QOF investment received for services (i.e., “carried interest”) eligible for QOZ tax benefits? Answer: No, services are not an eligible QOF investment and therefore not eligible for QOZ tax benefits. Prop. Reg. Section 1.1400Z2(a)-1(b)(9)(ii). Carried interest is treated as a “mixed investment” and tax items are prorated based on “allocation percentages,” with carried interest receiving an allocation based on highest residual profit sharing. The manager of a QOF may wish to hold its carried interest through a separate tax-regarded investment vehicle from its investment eligible for QOZ tax benefits. Separating the interests may be easier to administer and avoid the complications arising from a blended basis and holding period considerations related to the investment. Further, a multi-tranche carried interest will otherwise have a disproportionately high allocation percentage based on the highest residual carry sharing percentage. 2. Forced Section 1231 netting delays 180-day investment window start date to December 31 Question: Can Section 1231 “gross” gains be invested or does an investor have to wait until the end of its taxable to year to determine if there is any required Section 1231 loss netting? Answer: Only net Section 1231 capital gains are eligible for investment in a QOF, with 180 day investment period beginning on the last day of the taxpayer’s tax year. Prop. Reg. Section 1.1400Z2(a)-1(b)(2)(iii). Because Section 1231 netting generally occurs at the individual level, this may prevent partnerships from making QOF investments of Section 1231 gains. The forced delay in the start of the 180-day investment window also materially delays when investors can make QOF contributions and bunches all Section 1231 net gain investments into a QOF into the first half of each calendar year. These limitations do not apply to gains under Section 1221, such as gains from partnership cash distributions in excess of a partner’s basis in its partnership interest. Baker McKenzie 20 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation 3. Secondary QOF sales allowed -- buyers of QOF interest receive QOZ tax benefits Question: Are sales of interests eligible for QOZ tax benefits with respect to the purchaser? Answer: Yes, purchasers of existing QOF equity interest are treated as making an eligible investment in a QOF (starting a new 10-year holding period). Prop. Reg. Section 1.1400Z2(a)-1(b)(9)(iii). This is a significant expansion of QOF liquidity as it allows buyers of QOF interest before the December 31, 2026 investment window deadline to obtain QOZ tax benefits. This provides flexibility for a QOF to obtain “seed” investors who sell down later, or investors who need liquidity before December 31, 2026 to be able to find buyers to take over their investments in a tax-favorable manner. The buyer would still be required to designate qualifying capital gains toward the acquisition of the QOF interest. Note that sales after 2021 would be past the deadline to benefit from any of the 10% or 5% eliminations of deferred gain. 4. Determining allocation percentages for mixed investments Question: If a QOF investor holds mixed investments (e.g., contribution in excess of deferred capital gains) how is tax basis, income, and loss shared between the “eligible” investment and the remaining investment? Answer: Under the 2019 Proposed Regulations, income, loss, and Section 752 debt allocations are shared based on “allocation percentages” that compare the relative capital contributions between the two categories of investments, subject to Section 704(c) principles for a QOF partnership and by allocating a profits interest the highest percentage interest in residual profits attributable to the interest. Section 1.1400Z2(b)-1(b)(c)(6)(d)(i) Because a profits interest receives an allocation percentage equal to the highest possible residual profit share, it will receive a percentage that is higher than that to which it might economically be entitled. Because the regulations allocate Section 704(b) income with this artificially high residual allocation percentage, it could arguably make tax allocations greater than the profits interest economic share. Baker McKenzie 21 Tax News and Developments - Client Alert May 16, 2019 QOF Operational Considerations Topic 2019 Proposed Regulations Baker McKenzie Observation 5. In-kind QOF investments allowed Question: Can eligible QOF investments be made with in-kind property? Answer: Yes, tax-deferred eligible investments to a QOF can be made with cash or property, even if there is builtin gain or loss in the contributed property. Prop. Reg. Section 1.1400Z2(a)-1(b)(9)(i). However, any gain inherent in such in-kind property that is otherwise realized on the transfer is not itself eligible for QOF deferral. Prop. Reg. Section 1.1400Z2(a)-1(b)(2)(vi). Further, for in-kind property investments the amount of investment eligible for QOZ tax benefits is the lesser of the fair market value of the contributed property or the amount of its carryover basis (ignoring the impact of the QOZ rules). Prop. Reg. Section 1.1400Z2(a)-1(b)(10). The carryover basis rules of Section 723 apply to in-kind contributions such that the partnership inherits the partner’s basis in the property contributed. This allows a taxpayer to rollover in-kind property into a QOF and receive QOZ tax benefits. However, one concern is that the carryover basis contribution may not be treated as acquired “by purchase” as is required in the statute since the Section 179(d)(2) definition of purchase excludes carryover basis property. Another observation is that the Preamble specifically notes that allowing carryover basis combined with the investor’s basis step down in its outside QOF interest for the deferred gain may potentially lead to taxpayer manipulation. Comments have been requested on this issue. This appears to be the first place the 2019 Proposed Regulations address the “elephant in the room”: the apparent disconnect in a QOF partnership where investors have a basis step down in their outside QOF basis without a clear corresponding inside basis step down rule. It would be helpful if final regulations more clearly address this apparent insideoutside basis disparity and timing benefit to taxpayers if they receive full inside basis for cash or in-kind property that is represented by deferred gain. 6. New “disguised sale” rule disqualifies QOF investment if distributions too fast - rebuttable presumption for distributions within two years of QOF investment Question: Can distributions to a QOF investor soon after the initial investment nullify the qualification of the original investment as having been a tax-deferred eligible investment? Answer: The 2019 Proposed Regulations apply a modified version of the partnership disguised sale rules to determine if a distribution disqualifies (in part or The net effect of this new and unexpected disguised sale rule is to create a rebuttable presumption that all distributions from a QOF within two years from the original contribution disqualify the original eligible investment, even if the cash is funded from a pro rata debt-financed distribution (because the 2019 Proposed Regulations turn off this exception). Baker McKenzie 22 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation entirely) the qualification of the original investment in a QOF. Specifically, the 2019 Proposed Regulations treat any original QOF-eligible cash contribution as if it were an in-kind property contribution to the QOF, and with respect to debt-financed QOF distributions, the 2019 Proposed Regulations ignore a partner’s share of the debt supporting the distribution in determining whether there is a disguised sale. If, based on the modified disguised sales provisions, a subsequent distribution would be a disguised sale, the original eligible investment is reduced by the disguised sale amount. Prop. Reg. Section 1.1400Z2(a)-1(b)(10)(ii) and (iv)(C) Example 3. Although this rule is clearly geared towards what may be viewed as an inappropriate “cashing out” of the taxdeferred investment, it creates a facts-andcircumstances test that forces a QOF to carefully review distributions given the potential material loss of QOZ tax benefits. The disguised sale rules contain a number of exceptions (i.e., operating cash flow distributions), but these exceptions are very detailed and should be reviewed carefully, particularly for any distributions during the two-year disguised sale presumption window. For distributions after the twoyear window where the presumption is of no disguised sale, taxpayers should still carefully review any extraordinary distributions and the 10-factor facts-andcircumstances test (mostly looking at entrepreneurial risk) given that the IRS could still assert a disguised sale with dire consequences. Further, the two-year presumption period starts again with each subsequent contribution, so this should also be monitored. 7. New “inclusion events” accelerate deferred gain Question: What post-investment events can accelerate deferred gain prior to December 31, 2026? Answer: The 2019 Proposed Regulations list a series of “inclusion events” that accelerate the deferred gain in a QOF investment prior to December 31, 2026. Prop. Reg. Section 1.1400Z2(b)-1. To the extent of any inclusion, any income otherwise deferred until December 31, 2026 is accelerated. Prop. Reg. Section 1.1400Z2(b)-1(b). Inclusion events include, but are not limited to, the following: a. Termination or liquidation of QOF A material benefit of this list of inclusion events is that a standard pro rata partnership debt-financed distribution and certain cash distributions are not per se inclusion events to the extent that the distribution does not exceed the partner’s basis in its QOF interest (counting debt basis), provided the distribution is not recast as a disguised sale under the modified disguised sale rule discussed in #6 above. Any inclusion events that involve a reduction or elimination of the taxpayer’s QOF interest would also deny the taxpayer’s 10-year hold exclusion, since this would reduce or eliminate the investment held prior to reaching the 10-year mark. Note that if a taxpayer is Baker McKenzie 23 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation b. Taxpayer transfer of QOF interest (subject to exceptions such as the exception for transfers of QOF interests to lower-tier partnerships under Section 721(a)) c. QOF distribution to taxpayer (subject to exceptions such as a distribution by a QOF partnership to a partner is only an inclusion event to the extent that the fair market value of the distribution exceeds the partner’s basis in the QOF partnership, taking into account the partner’s share of basis attributable to partnership debt) d. Taxpayer reporting worthlessness deduction for QOF interest e. Liquidation of QOF owner (subject to exceptions) f. Transfer of QOF interest by gift (excludes transfers to grantor trusts) g. Distribution by QOF partnership in excess of partner’s basis h. Application of remaining deferred gain reduction rule i. Distribution by QOF C corporation j. Qualifying Section 381 transaction k. Section 355 transaction l. Recapitalization m. Section 1036 transaction Transfers by reason of death are generally not inclusion events, subject to exceptions. particularly concerned about tax rates increases prior to the 2026 inclusion date, they may consider intentionally triggering an inclusion event, at the cost of giving up future QOZ tax benefits. Baker McKenzie 24 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation 8. QOF can lease property, even from related parties Question: Can leased property be QOZ Business Property? Answer: The 2019 Proposed Regulations provide for special valuation and qualification rules for assets leased by a QOZ Business. Property leased by a QOZ Business through a market rate lease entered into after December 31, 2017 can qualify as a QOZ Business. Further a lease from a related person is allowed, subject to additional restrictions such as not allowing pre-payments in excess of 12 months of rent and having arm’s length lease provisions under Code Section 482. Prop. Reg. Section 1.1400Z2(d)-1(b) and (c). The 2019 Proposed Regulations confirm that a QOF that would otherwise have a “bad” asset that is owned by a person related to the QOF can obtain use of such bad asset through a market rate lease. The 2019 Proposed Regulations confirm the specific constraints of how to structure such a lease. This may become a common method to obtain the use of QOZ property from a related party if the QOF does not want the asset to count toward its allowable 10% or 30% “bad” assets, depending on whether the purchase was the QOF or a lower-tier entity owned by the QOF. 9. Measuring substantial improvement with multiple tangible assets Question: If a QOF holds multiple related assets within a QOZ, how is substantial improvement measured? Answer: The Preamble provides that the “doubling of the basis” test for substantial improvement for tangible property that is purchased is made on an asset-by-asset basis, although Treasury has asked for comments on an aggregation approach for related assets. This rule creates substantial uncertainty and practical difficulties for real estate development, which often involves multiple related assets on a single or on continuous parcels. The 2019 Proposed Regulations cause further confusion by not defining what an “asset” is for this purpose. It is unfortunate that the 2019 Proposed Regulations stated that asset-by-asset is the default rule when they seemed sympathetic to an aggregation approach. It would have been better to simply state that the IRS was still considering the right course of action so that taxpayers could take a reasonable approach in the interim rather than force an asset-by-asset approach for taxpayers needing to rely on the 2019 Proposed Regulations generally given the significant problems with the asset-by-asset approach and the uncertainty as to how “asset” is defined for this purpose. Baker McKenzie 25 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation 10. Defining “substantially all” for holding period Question: How is “substantially all” defined with respect to the QOF’s holding period of eligible property? Answer: The 2019 Proposed Regulations define “substantially all” as 90% of the holding period. Prop. Reg. Section 1.1400Z2(d)-1(b)(5). This 90% standard allows only a very limited window for a QOF to fail its 90% or 70% qualified asset test, putting even more pressure on meeting the tests for every applicable 6-month period. A 90% test means failure of more than one period every five years would cause a corresponding failure of this holding period test. 11. Tangible QOZ property’s original use begins with “placed in service” date Question: When does “original use” in a QOZ begin with newly constructed property? Answer: The 2019 Proposed Regulations provide that original use of tangible property in a QOZ begins on the date any person first places the property in service in the QOZ for purposes of depreciation or amortization. Further if property has been unused or vacant for an uninterrupted period of at least five years, original use in the QOZ commences on the date after that period when any person first so uses or places the property in service in the QOZ. Prop. Reg. Section 1.1400Z2(d)-1(b)(7). The 2019 Proposed Regulations confirm that a QOF need not construct a new property as long as it acquires the property prior to the date it is placed in service in a QOZ, provided the developer held the property as inventory and not as an investment that the developer depreciated (or could have depreciated). The QOF should establish that the developer held the property as “inventory” and not as a depreciable investment. This will allow a QOF to avoid much or all of the construction risk associated with building a property and allow the QOF to participate in the role of investor (in an active business asset) without being the actual developer. 12. General qualification of unimproved land but no land banking Question: Can a QOF acquire unimproved land? Answer: The 2019 Proposed Regulations allow a QOF to acquire unimproved land in a QOZ by purchase without a requirement to substantially improve such land. Prop. Reg. Section 1.1400Z2(d)-1(b)(8)(ii)(B). However, a vague anti-abuse rule concludes that land does not qualify as “good” property if the land is unimproved or minimally improved and the QOF or the QOZ Business purchases the land with an expectation, an intention, or a view not to improve the land by more than an This solidifies the implication of the prior guidance that unimproved land, although never satisfying the “original use” requirement, does not need to be “substantially improved” to count as a good asset. However, the land must not be vacant but be used as part of an active trade or business because (1) the second limitation prevents “land banking” and (2) there is the general requirement that the QOF operate a Section 162 trade or business. The Preamble specifically concludes that using QOZ land “for the production of an agricultural crop” without investing Baker McKenzie 26 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation insubstantial amount within 30 months after the date of purchase. any new capital investment in, or increasing any economic activity or output of, that parcel would be an inappropriate result. This raises questions for other more sympathetic uses such as raising long-term trees or other active farming operations that involve substantial capital investment and activity. 13. Alternative tests for operating businesses to qualify as being located in a QOZ — sales outside of QOZ allowed Question: How does an operating business test whether it satisfies the requirement that 50% of its gross income be within a QOZ? Answer: The 2019 Proposed Regulations provide four alternative tests for an operating business to satisfy the more than 50% revenue within the QOZ test as follows: (1) more than 50% of the hours performed by employees or independent contractors performed within the QOZ; (2) more than 50% of the amount paid for services performed within the QOZ over total amount paid for services, (3) the tangible property of the trade or business located in a QOZ and the management or operational functions performed in the QOZ are each necessary for the generation of at least 50% of the gross income of the trade or business; or (4) based on all the facts and circumstances, at least 50% of the gross income of a QOZ Business is derived from the active conduct of a trade or business in the QOZ. Section 1.1400Z2(d)-1(d)(5). The four alternative tests are a welcome and necessary prelude to the qualification of non-real estate operating businesses as a QOZ Business and confirm that a business that sells its inventory outside of the QOZ Business is not harmed as long as the majority of the employee and independent contractor work is done in the QOZ Business. Practically speaking, existing business may be unable to efficiently move to a QOZ due to the requirement that QOZ properties be acquired by purchase. However, this provision may be useful to existing operating businesses seeking to expand into a QOZ that will purchase assets for that business in the QOZ. Property is treated as acquired by purchase only if it is not acquired from a “related party,” as that term is used in Sections 707(b)(1) and 267(b), with “20 percent” substituting “50 percent” each time “50 percent” appears in the statutes. How the related-party rule is applied for measuring carried interest remains an open issue. Baker McKenzie 27 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation 14. Section 162 test for required active trade or business -- special rules for real estate Question: What is the minimum QOZ Business activity level to be an active trade or business? Answer: The 2019 Proposed Regulations apply the Section 162 trade or business standard, generally requiring considerable, regular, and continuous activity. Special real estate rules provide that (1) solely for the purposes of Section 1400Z-2(d)(3)(A), the ownership and operation (including leasing) of real property is the active conduct of a trade or business, but (2) merely entering into a triple-net-lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer. Although the general rule for treating real property operation as a trade or business is welcome news, the 2019 Proposed Regulations create material uncertainty with the carve-out for merely entering into a triple-net-lease. Hopefully, a taxpayer is not “merely” entering into a triple-net-lease if the taxpayer also built the building such that there has been substantial construction activity. However, given the uncertainty, for triple-net-leases not yet entered into, the taxpayer should focus on adjusting them so that the landlord is active enough and the leases are not treated as triple-net-leases (e.g., the landlord could pay certain common area maintenance costs or fund the property taxes directly and build it into the rent). QOZ Businesses will have to evaluate existing leases to determine whether they should negotiate for any revisions to provide additional activity for QOZ purposes. 15. Expansion of working capital safe harbor Question: Are there new and/or practical exceptions to working capital safe harbor? Answer: The 31-month working capital safe harbor for cash investment pursuant to a plan to invest in qualifying assets within 31 months is modified to (1) allow the written designation to cover development of a trade or business in the QOZ as well as development activities, and (2) provide that exceeding the 31-month period for deploying capital does not violate the safe harbor if the delay is attributable to waiting for government actions. The expansions to the working capital safe harbor are a welcome addition and provide greater flexibility for capital raises and subsequent deployment. Additionally, the recognition that delays resulting from government actions do not violate the safe harbor is beneficial for developers accustomed to long construction timelines and unexpected issues involving government actions. The QOFs should keep track of the dates and filings of all government-approved requests in order to accurately calculate all tolling of 31-month period. Baker McKenzie 28 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation 16. Qualification of property straddling outside of a QOZ Question: Can property that straddles a QOZ still qualify as property that gives rise to QOZ benefits? Answer: Yes, contiguous property outside of the QOZ can be counted if the value of the real estate for the development project located inside the QOZ is “substantial” in comparison to the value of the real estate for the development project located outside the QOZ. The Preamble states that this test is met if the unadjusted cost of the real property located inside a QOZ is greater than the unadjusted cost of real property located outside the QOZ. Inconsistently, however, the regulatory text provides that real property straddling a QOZ boundary will be deemed to be located inside the QOZ if the square footage of the real property located inside the QOZ is considered “substantial.” Although the straddle rule is helpful, the inconsistency in tests between the Preamble (based on relative costs) and the text (based on relative square footage) puts taxpayers in a quandary. Although regulatory text would generally trump the Preamble, a conservative route would be to apply the more restrictive of the two tests. Further, it would be helpful if the final regulations clarify whether the tests are applied before or after development (e.g., whether the square footage test looks only to the square footage of the land itself or whether it takes into account the developed square footage of the property). Baker McKenzie 29 Tax News and Developments - Client Alert May 16, 2019 Exit Considerations Topic 2019 Proposed Regulations Baker McKenzie Observation 17. QOF-level sales and reinvestment restrictions Question: What are the parameters associated with QOF-level sales and reinvestment period? Answer: The 2019 Proposed Regulations allow the QOF 12- months to reinvest proceeds of sales by the QOF before the proceeds of the sale will count as a “bad” QOF asset. However, the 2019 Proposed Regulations clarify that the tax treatment of such fund-level sales follow normal taxable rules and thus are taxable absent another exception, such as Section 1031, or absent the basis increase push down election for investors with a 10-year holding period. Although a QOF has 12 months to find suitable replacement QOF assets, absent an exception such as a Section 1031 like-kind exchange, fund-level sales before and after the 10-year holding period will create current tax for the QOF members. If Section 1031 is used to defer gain during the interim, the “acquired by purchase” requirement for the ultimate QOZ replacement property should be analyzed. 18. 10-year basis step-up includes recapture and debt share Question: Does the 10-year basis step-up in a QOF partnership interest immediately prior to a QOF interest sale include the partner’s share of partnership debt and the partnership’s share of ordinary income assets such as depreciation recapture? Answer: Yes, the 2019 Proposed Regulations adjust the partner’s basis in partnership interest to full fair market value, including debt, and, the basis of the QOF partnership assets are also adjusted immediately prior to the sale using the rules under Section 743(b) (which then step-up the inside basis in both capital gain and ordinary income assets). A similar rule applies to capital gain dividends from a QOF REIT. Prop. Reg. Section 1.1400Z2(c)-1(b)(2)(i); Prop. Reg. Section 1.1400Z2(c)-1(d)(2) Example 2; and Prop. Reg. Section 1.1400Z2(c)-1(e). Consistent with the statute, this steps up the basis in a sold QOF interest to the full gross fair market value, and goes further to push such step-up to the assets (capital and ordinary) in the same manner as if a cash sale of interest occurred. The net result is that the basis step-up covers true net appreciation and offsets any basis reduction from depreciation deductions that were offsetting an investor’s share of QOF operating income. The depreciation recapture step-up means, in effect, that the typical timing benefit of depreciation deductions becomes a permanent benefit after the 10-year hold is achieved. Baker McKenzie 30 Tax News and Developments - Client Alert May 16, 2019 Topic 2019 Proposed Regulations Baker McKenzie Observation 19. 10-year basis step-up for certain QOF-level sales Question: Can an investor’s election to increase basis in a QOF interest after 10-years apply to the underlying QOF assets? Answer: The 2019 Proposed Regulations allow taxpayers in QOFs that are partnerships or S corporations to make an election after the requisite 10-year holding period to exclude capital gains and net Section 1231 gains on qualifying QOZ investments reported on their Schedule K-1. Prop. Reg. Section 1.1400Z2(c)-1(b)(2)(ii). Unlike the complete exclusion of all gains inherent in a QOF interest allowable on a sale of QOF interest described in #18 above, the election to exclude gains from a QOF-level sale is limited to only capital gains from qualifying QOF investments and does not avoid ordinary recapture income or income from non-QOF assets. Further, the election appears to only exclude gains recognized directly at the QOF level and not gains recognized in a QOZ partnership held by a QOF. The net effect is that this election is materially less advantageous than the basis step-up on the sale of a QOF interest. The fault may simply be regulatory drafting errors, but unless and until fixed, this election is not the solution taxpayers were expecting in order to avoid the logistical problem of otherwise needing to sell QOF interests to receive the full 10-year basis step-up benefit.